[This review was published in the Winter 2012 issue of The Journal of Social, Political and
Economic Studies, pp. 546-552.]

Book Review

Confidence Game: How a Hedge Fund
Manager Called Wall Street’s Bluff

Christine S. Richard

John Wiley & Sons, Inc., 2010

Many of the books
about the recent financial crisis discuss the financial system in general and
analyze the complex mixture of flaws and abuses that caused the debacle.Others approach the subject by telling the
story of individual companies and personalities.Confidence
Game is one of these, centering on a particular episode that serves as a
microcosm that illustrates the whole. The story it tells is fascinating,
notwithstanding this reviewer’s opinion that it is longer and more detailed
than it needs to be.

In 1993, Bill Ackman and his fellow graduate of the
Harvard Business School David Berkowitz co-founded the Gotham Partners hedge
fund, starting with $3 million and increasing its assets to over $350 million
by 2001.It appears that Ackman used the
fund in part to engage in a rather odd but highly profitable pursuit. No one
would expect the author of this book, Christine Richard, to match Victor Hugo
stylistically, but as a bond market business reporter first for Dow Jones and
later for Bloomberg News she has
fashioned a readable, novel-like narrative that could well be described as the Les Miserables of the recent financial
debacle.She follows Ackman from day to
day as over several years he tormented – as in Hugo’s book police inspector
Javert stayed on the tail of Jean Valjean – a giant
quarry known as the Municipal Bond Insurance Association (MBIA).Predicting MBIA’s eventual downfall to all
who would listen, Ackman shorted MBIA’s stock and purchased, at a cost of about
$10 million a year, almost two billion dollars’ worth of “credit default swap”
contracts (i.e., insurance contracts) that would pay off to his fund if MBIA
took bankruptcy.In the end, as things
came to smash during the financial crisis, his fund wound up making $1.1
billion from the shorting of the stock, as the credit-rating agencies stripped
the MBIA of the triple-A rating that was essential to its business as a
municipal bond insurer.

Ackman made constant complaints against MBIA – in an October
2002 letter to his investors explaining why he was massively shorting MBIA’s
stock, to regulators, in talks with a Wall
Street Journal reporter, in presentations to financial analysts, in a
66-page report, and, among other such contacts, in a letter to the board of
directors of Moody’s, one of the three large credit-rating agencies. Ackman
explained in his letter to his investors that the gist of his criticisms was
that “we believe [MBIA] has inadequate reserves, undisclosed credit-quality
problems, aggressive accounting, and substantial unconsolidated indebtedness
contained in off-balance-sheet special-purpose vehicles.”A thread that runs through the book is the
question of whether Ackman was trying to manipulate the market, causing MBIA’s
stock to fall, so that his fund could profit from its decline.The somewhat surprising answer, as Richard
explains, is that it is not unlawful as market manipulation to attack a company
if everything that is said is true, even if the person making the attack and
contributing to the company’s decline in the market stands to profit from doing
so.

Although Richard
focuses on Ackman’s dogged contrarianism, it is a
necessary and valuable part of her book to explain the intricacies of the
business of insuring municipal bonds.It
turns out that she can hardly do this without also explaining the vast
multi-trillion dollar web of financial relationships in several of the
different dimensions of the financial world.Her explanations make this book a combination of a Hugo-type novel and a
primer for laymen about the financial crisis, each aspect interwoven with the
other.We simultaneously follow Ackman’s
pursuit of MBIA and read Richard’s descriptions of the incredibly complex
financial world that was constructed in the few years immediately prior to the
crash in 2008.

If we are to
understand all this, it is best to start by knowing just what sort of business
MBIA conducted.As its name suggests, it
was heavily involved in insuring the bonds issued by municipalities – towns,
cities and counties.By being triple-A
rated by the credit-rating agencies, its act of insuring the bond issues
allowed those issues to themselves receive a triple-A rating.This greatly facilitated the financing of the
various projects pursued by local governments.Because the triple-A rating was given to the bonds and they were backed
by a triple-A rated insurance company, purchasers of the bonds were able to buy
them with what was tantamount to complete assurance that they were
risk-free.The triple-A rating was
enough; counting on it, the buyers were relieved of the need to do a “due
diligence” inquiry themselves into the credit-worthiness of the bond issue.This is worth mentioning because many
trillions of dollars of financial transactions of all types came about through
overlapping reassurances that – like a house of cards – created a false sense
of confidence and encouraged the accumulation of enormous leverage (borrowing)
without regard to whether the underlying fundamentals were sound.Hence, the name Confidence Game for this book.

What especially
caught Ackman’s critical eye about MBIA’s role as an
insurer of the bonds was that it sold the insurance with almost no reserve to
stand behind it.“The Gotham report
pointed out,” Richard says, “that MBIA was levered 139 to 1.The company had guaranteed principal and
interest payments on bonds totaling $764 billion and had $5.5 billion of
shareholders’ equity.” The rationale for its doing so was that there was virtually
no chance any of the municipal bond issues would go into default.Why?Because experience had shown that the national government will not sit
by to allow a state government to default, and state governments will in like
fashion stand behind their local entities.[1] This state backing meant,
in effect, that the bond insurer (MBIA and others such as Ambac) was not a
primary insurer, but rather a re-insurer who would have to pay only if the
local entity didn’t and its state didn’t come to the rescue. The credit
agencies gave bond insurers a triple-A rating despite the lack of reserve
because they knew, just as the insurer did, that the insurance was granted to
cover losses that would almost never occur.

What purpose did the
bond insurance serve, then, in exchange for the premiums paid for it?In substance, none; but quite a substantial
purpose as a significant strand in the ensuing confidence-based web of
financial structures.As we have seen,
the municipal bond issues were given triple-A ratings by virtue of the extra
veneer given to them by being insured by a triple-A insurance company.[2]It was this that made the bonds – almost
three-quarters of a trillion dollars’ worth – readily saleable.

What also caught Ackman’s eye was that MBIA, in addition to its
bond-insurance business, acted through a “special-purpose vehicle” (SPV)[3] to sell billions of
dollars’ worth of “credit default swaps” (CDSs) to stand behind “collateralized
debt obligations” (CDOs).A CDS, despite
its obscure name as a “swap,” is actually a contract insuring a security.The CDOs that were insured by such contracts
were pools of securities that were ultimately based on the subprime mortgages
that the crisis showed to be so shaky.The CDO structure was almost beyond belief: as many as 1,000 mortgage
loans would be bundled into a bond, and a hundred of these bonds would go into
a CDO.To create what was called a
“CDO-squared,” 50 of the CDOs were bundled together.An insurer or a buyer of a CDO or CDO-2
certainly couldn’t make a “due diligence” examination of the many tens of
thousands of underlying loans, but instead had to rely on the triple-A rating
given them by the rating agencies. Ackman called “the triple-A ratings Moody’s
has placed on subprime mezzanine CDOs” an “absurdity.”[4] One of his criticisms of
MBIA was that it had “set aside only $10 million
of reserves for losses against its entire $65 billion [CDO] portfolio” [our emphasis].(MBIA did hedge against its lack of reserves
by getting re-insurance from other companies against its own insurance
obligations.This manifests still
another layer in what was quite a Byzantine web.)

As we have seen, the
credit-rating agencies stood at the center of this web.The weakness of their business model
accordingly played a key role in bringing about the financial crash.Richard points to a “basic flaw”:
“Credit-rating companies insisted on diversification: a range of loan originators
and servicers, wide geographical distribution, and various loan sizes… What
[they] overlooked was the time frame, or the so-called vintage, in which the
loans were made.Vintage turned out to
be the single most important factor… Loans made in 2006 and 2007 were made to
people who borrowed as much as they could to purchase houses they couldn’t
afford when prices were peaking.”This
meant that the agencies were “underestimating correlation risk” [i.e., the risk
that seemingly unlike things would wind up acting alike, such as defaulting at
approximately the same time].Moreover,
“faulty statistical models [were used by the financial industry] that rely on
the past to predict the future,” according to Ackman’s report.Richard says that models were built “to
predict the future performance of mortgages using just five years of data, and
data taken from a period of strong economic growth, no less.”A remarkable example of how far off the
models could be was provided by Ackman when he pointed out that “historical
data-based models considered the 1987 stock market crash an event so improbable
that it would be expected to happen only once in a trillion years.”

Sociologists will long
marvel at how so many super-intelligent people – “lawyers, auditors,
credit-rating analysts” and others, including regulators, bankers, mortgage
brokersand hedge fund managers – could,
in Richard’s words, go together “to construct rickety financial structures.”Indeed, there was much more to it than we
have been able to suggest here.The
“structured finance market” became “the epicenter of Wall Street innovation.”The financialization of the American economy
is graphically described by Richard when she says that “financial sector debt –
at $17 trillion – had grown from about 15 percent of gross domestic product in
1976 to 120 percent in 2008.”She goes
on to say that “this explosion of debt transformed Wall Street into a place of
extraordinary wealth, where even those far down in the ranks came to expect
multimillion-dollar bonuses.”[5]

It is reassuring to
know, even though Richard herself does not say so, that this is past
history.Confident in the wisdom and
virtuous self-restraint of our fellows, we have reason to believe that the
lessons have been learned and that the future will bring no repetition of such
venality and over-cleverness.This means
we can accept Confidence Game as
comfortable bed-time reading, and have sweet dreams afterwards.

Dwight D. Murphey

[1] Tellingly, Richard recountsan instance in which Oklahoma showed
reluctance to stand behind a county bond issue, but was in effect forced to do
so when MBIA threatened to withhold insurance for all other issues in the
state.

[2] Since the credit-rating agencies knew the insurance
really wasn’t needed, they could just as well have granted triple-A status to
the bond issues even in the absence of the insurance, but they didn’t.Instead, they “massively underrated” the bond
issues, according to Richard, making the insurance necessary.

[3] The reason, Richard says, for MBIA to go through a
special-purpose vehicle was to get around a legal restriction on insurance
companies’ engaging in derivative transactions.It was held to be lawful, however, for an insurance company to be the
re-insurer of the special-purpose vehicle’s obligations. By serving as the
re-insurer for the SPV, the MBIA made it an entity with which the buyers of the
CDOs were willing to deal.

[4] The term “mezzanine CDO” refers to a CDO made up of
bonds that have only a middle priority in terms of receiving payment from the
loans that feed into the bonds.There
are bonds that have a higher priority for payment, occupying a “senior tranche”
in the slicing and dicing that went into the creation of mortgage bonds; and
there are other bonds with a lower priority.

[5] The immense size of the financial bubble is
strikingly illustrated when Richard points out that the U.S. government’s $180
billion bailout of American International Group (AIG) (just part of the total
late-2008 bailout package) was “a larger commitment in inflation-adjusted
dollars than the Marshall Plan that
rebuilt Europe after World War II” [our emphasis].